Indexed Universal Life (IUL) insurance sounds like an executive’s retirement funding dream: a financial product with flexible premiums, the potential for market-linked growth, and a safety net for retirement. The cap on your plan is set by your insurance company, and the way caps are being handled by the insurance industry is a key contributor to the failure of many Supplemental Executive Retirement Plans (SERPs). Our aim with this article is to help you understand these complex offerings and be better able to ask good questions about them. Our overall vision is for you (and every executive) to avoid receiving a bad news letter saying your retirement plan will fail to deliver the promised benefit.
In this article, we’ll delve into how IUL caps work and what makes them problematic, leading us at PARC Street Partners to choose not to use them—instead opting for whole life insurance from a mutual insurance company—to set up a SERP.
We hope that after reading this article, you’ll want to more fully understand the risks of IULs by reading our comprehensive whitepaper—and ultimately decide to implement your SERP with whole life instead.
Why what you see now might not be what you get later
Strict rules dictate how the performance of IUL policies are illustrated[1], and projected. The maximum allowed crediting rate of return, the most the insurance company can project what the policy can earn in a year, is based on actuarial guidelines (AG 49) from the National Association of Insurance Commissioners (NAIC), which sets standards and best practices for the industry.
But even with strict guidelines in place, it’s important not to take positive statements about IUL at face value.
When consultants come to your credit union to talk with you about life insurance-based SERPs, they’ll often suggest using an IUL as the foundation for your plan because of its “upside potential and downside protection.” They’ll say that the policy has a “zero floor, so you can’t lose money when the market goes down.”
Then they’ll present an illustration with an illustrated rate for the performance of the IUL policy they hope you’ll buy. If you already own such a policy, you probably remember this presentation.
But while IUL-based SERPs are designed for upside potential with downside protection, they may still have years of unacceptably poor performance that will negatively impact your benefit at retirement.
And while the floor on these policies is typically zero, policy charges and bad luck at the wrong time might still put your policy underwater in tough market years.
It’s also really important to have clarity about this fact: the illustrated rate used in the illustration of the potential growth of the policy's cash value and benefits is hypothetical. It is not a guaranteed rate, but an illustration of how the policy might perform under certain conditions, based on certain assumptions. That’s a lot of uncertainty about a product you’re considering using to support your retirement plan.
The cap conundrum
So, how exactly do IUL caps work, and how do they contribute to IUL being so significantly problematic for retirement plans?
With an IUL-based SERP, the insurance company sets the annual cap, or limit, on what the plan can earn, tying it to an underlying index like the S&P 500. For a principal amount of $100,000 with a cap of 8%, for example, the “annual policy credit” to the plan is limited to $8,000—even if the underlying index is up 25%. We want to stress that the cap determines the true performance of an IUL, not how well the underlying index performs.
While the cap on its own is a limitation on the upside of IUL, a deeper issue is that insurance companies have consistently lowered their caps over the last 15+ years, resulting in a material reduction in upside potential for existing IUL policy owners.
Insurance companies have been forced to lower IUL caps because of two factors: interest rates and options pricing.
To create upside potential and downside protection on an IUL policy, the insurance company executes an options strategy. How much money the insurance company has to execute this strategy is based on how much money it has to spend. This is also known as the “options budget,” which is determined by the yield on the company’s general account, where policy premiums it receives are deposited. So, lower interest rates mean less yield on the general account and therefore less funding for executing the options strategy.
At the same time that the options budget has gone down, the cost of options has gone up. When IULs were introduced about 15 years ago, option pricing was low due to inefficiencies that are normal in a new market. Over the years, option prices have increased as the market has become more efficient, due to the popularity of index-based products, such as IULs and indexed annuities.
In all, the companies have had less funding to buy something that’s more expensive.
This situation has forced virtually all insurance companies to reduce caps significantly, from approximately 13% a decade ago to around 8% today.
But that’s not the only squeeze IUL policyholders feel from caps.
In recent years, virtually all insurance companies have also “de-linked” IUL policies, which means they created separate blocks of policies. Each block has a different cap based on when the policies in it were purchased.
This de-linking strategy allows newly introduced policies to illustrate much better because they benefit from the rise in interest rates that results in a higher options budget. IULs sold seven years ago might have an 8% cap, while IULs sold today might have a 10% cap.
Notably, today’s new policyholders might eventually be part of an “older” block, limiting their plan’s potential to the cap assigned to that block.
Why you need to know more
This article describes only one of the two key risks of using indexed universal life insurance as the foundation for your executive retirement plan. Whether you’re an executive or a board member, it’s worth your time to learn more so you can avoid setting up a plan with an unacceptable worst-case outcome—that is, one that fails to deliver the projected benefit to the executive at retirement! We think if more executives and boards fully understood these risks, they would structure their plans like we do, conservatively and using whole life insurance from a mutual insurance company rather than with IUL.
Your retirement deserves the best planning possible. We’re ready to help you sort through the options. Access our free whitepaper for a complete look at the key IUL risks and learn strategies for avoiding an unacceptable outcome.
After more than 10 years specializing in split-dollar Supplemental Executive Retirement Plans at OM Financial Group, Bruce D. Smith, CFA, co-founded PARC Street Partners, a member of PARC Street Group, with Chris Jones. Bruce brings more than four decades of experience in financial services and prides himself on radical responsiveness and exceptional service.
Bruce and Chris have implemented more than 200 split-dollar plans in the credit union and non-profit industry since 2014. Virtually every plan they’ve implemented is on target to deliver the original benefit at retirement and, in many cases, more than projected. This is due to their conservative nature, careful analysis, thoughtful plan design, and use of whole life insurance from mutual companies.
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[1] A life insurance illustration is a document provided by an insurance company that shows how a life insurance policy is expected to perform under different scenarios. It's a hypothetical projection, not a guarantee, of how the policy's cash value and death benefit might change over time, based on various assumptions.
